Source: China International Capital Corporation Insight
Authors: Liu Gang, Yang Xuanting, Xiang Xinli

At the conclusion of the March FOMC meeting, which ended in the early hours of today Beijing time, the Federal Reserve's decision to maintain the benchmark interest rate at 4.25 to 4.5% met expectations. Before the meeting, there was a consensus in the market about the Federal Reserve pausing interest rate cuts, with the CME Interest Rates futures pricing in a 99% probability of a pause in March. Therefore, the focus of this meeting was more on how the Federal Reserve will respond in 2025 to a weakening economy on one hand, and concerns about supply inflation brought by the volatility and randomness of tariffs and policies since Trump took office on the other; will it be able to lower interest rates again?

If the downward pressure on the economy is merely a natural occurrence, the Federal Reserve can quickly resolve the issue by cutting interest rates, which we believe is not a concern, similar to September 2024; however, if there is also a challenging supply-side inflation issue, then the Federal Reserve can only face declining growth without taking action, and might even face pressure to raise rates, similar to 2022, which is what the market is worried about.

Chart: Before the meeting, the probability of a pause in interest rate cuts in March implied by CME Interest Rates futures reached 99%.

Chart: After the meeting, CME Interest Rates futures implied that interest rate cuts would start in June, with a total of three cuts occurring within the year.

In this sense, the meeting can be considered slightly "dovish". The Federal Reserve maintained its prediction of two rate cuts this year, indicating that the cumulative net effect of various changes since December last year has not led the Federal Reserve to lower its rate cut expectations, which is better than the market's worries. Therefore, after the meeting's resolution, the yield on U.S. Treasuries decreased, and U.S. stocks rebounded.

What information did this meeting convey? Maintaining a wait-and-see approach due to uncertainty, there are still two rate cuts within the year, and the economic forecast is "stagflation-like," with a slower pace of balance sheet reduction.

Maintaining the benchmark interest rate at 4.2% to 4.5%, in line with expectations. In the January FOMC, Powell stated that the conditions for rate cuts are to see actual progress in the decline of inflation and weakness in the job market ("Pausing a rate cut to continue cutting rates"). The non-farm and inflation data published for January and February are still resilient, not to mention that risks from tariffs and supply-side inflation are still lingering. Therefore, pausing rate cuts in March has already become market consensus, with CME Interest Rates futures indicating a 99% probability of a pause in March.

"Dot plot" expects two rate cuts in 2025, better than expected. Despite the increasing uncertainty of inflationary policies such as Trump's tariffs and immigration, the dot plot shows that there are still two rate cuts (3.75% to 4%) in 2025, consistent with the dot plot at the end of December 2024. This indicates that the cumulative net effect of various changes since December last year (worries about slowing growth and concerns over supply-side inflation pressures due to policy uncertainty) has not led the Federal Reserve to downgrade its rate cut expectations, which is better than what the market feared. This also helps alleviate the short-term market's tension over fears of uncontrolled supply-side inflation preventing rate cuts.

Chart: The March dot plot shows that there is still room for two rate cuts in 2025.

Lowering growth and raising inflation and unemployment rate forecasts. This FOMC meeting also adjusted future economic data forecasts, reducing the actual GDP growth rate for 2025 from 2.1% in December to 1.7%, raising the PCE inflation level from 2.5% in December to 2.7%, with the unemployment rate slightly increasing to 4.4%, showing a "quasi-stagflation" situation. This risk was already hinted at in "The Truth About Weakening Growth in the USA"; weak growth is a natural effect of the previous high interest rates, and high inflation expectations stem from intensive statements on tariff policies and worries about increasing uncertainty. Until the changes in the reflexivity of interest rates and the implementation of tariffs occur, short-term risks cannot be falsified, which is also one of the main reasons for the recent pullback in the US stock market; trading can only occur in a "quasi-stagflation" atmosphere.

Chart: The Federal Reserve raised inflation and unemployment rate forecasts in the March FOMC, lowered growth expectations, and kept the neutral interest rate unchanged.

Reducing balance sheet and lowering speed to prevent liquidity shocks. The Federal Reserve announced at this meeting a reduction in balance sheet from $25 billion a month to $5 billion, in order to avoid exacerbating the contraction of liquidity against the backdrop of an unresolved debt ceiling, which could lead to a "money shortage" situation as seen in 2019. According to our calculations, the USA's TGA account could last until mid-year, and the debt ceiling needs to be resolved before that, which means the Federal Reserve needs to act sooner and reduce the balance sheet in a timely manner to hedge risks. 1) Current reverse repos are nearly exhausted; the overnight reverse repo scale, which once exceeded $2 trillion, has now fallen to about $150 billion; 2) The liquidity level measured by reserves/bank assets is close to a critical point, with 12%-13% being the threshold for excessive and moderate liquidity, while 8%-10% is the alert line for a lack of liquidity. This metric has been on a downward trend since April 2024, dipping to 12.4% on January 1, 2025, reaching the moderate liquidity threshold, and currently stands at 14.2%. Therefore, slowing down the balance sheet reduction in advance helps prevent liquidity shocks.

Chart: Current reverse repos are nearly exhausted; the overnight reverse repo scale, which once exceeded $2 trillion, has now fallen to about $150 billion.

Chart: The debt ceiling is in effect, and the TGA Account balance is being rapidly consumed.

What will the future policy path and space be? The implementation of tariffs will delay the interest rate cut timing, while the opposite scenario will open up space for rate cuts due to inflation behavior.

Federal Reserve Chairman Powell emphasized the word "uncertainty" the most in this meeting, highlighting that a significant portion of the variability comes from the randomness of tariff policies. Overall, the weakening of growth (but low recession pressure) and the rise of inflation risks (mainly due to tariff disturbances) have had a mutually offsetting effect, thus keeping the Federal Reserve's expectations for rate cuts unchanged throughout the year. This also implies two layers of meaning: first, if it weren't for tariff risks, the Federal Reserve could have cut rates long ago; second, if tariffs were significantly implemented, it would force the Federal Reserve to delay rate cuts, so the focus remains on watching for now.

Looking ahead, the timing and path of future rate cuts depend on: 1) the natural economic path, where we estimate inflation will continue to decline until May (overall CPI low point at 2.6%), and the reflexivity of the rate downtrend that began in mid-January has yet to show, thus providing a window for rate cuts during this period. 2) The speed and intensity of tariff policies. Since Trump's administration, the frequent indications and uncertainties regarding tariffs have kept the market in a state of supply-side inflation concern. If tariff risks escalate, they may even obstruct the reflexivity of interest rates in transmitting to growth, and in extreme cases lead to supply inflation pressures, putting upward pressure on the Federal Reserve to raise rates ("The 'Immediate Concerns' and 'Long-Term Worries' of Tariffs"). Recent data also reflects this signal, as the Michigan consumer survey's inflation expectations for the next year jumped from 3.3% in January to 4.3% in February, marking a significant increase for the second consecutive month, the highest value since November 2023.

Chart: We estimate that inflation will continue to decline until May (overall CPI low point at 2.6%).

Chart: The Michigan Consumer Survey's inflation expectations for the next year jumped from 3.3% in January to 4.3% in February.

The impact of tariffs is currently more in the "noise phase", with limited real implementation. Although since Trump's inauguration the tariff policy has encountered enemies on all sides, the only actual implementation has been the 20% tariff imposed on China and some Steel tariffs, while tariffs on Canada, Mexico, and the EU have been delayed indefinitely. According to previous calculations by PIIE, imposing an additional 10% tariff on China could raise US inflation by 0.1 percentage points by 2025, and even a 60% tariff could raise it by about 0.7 percentage points, which is not a significant impact. However, the issue is that both the market and the Federal Reserve cannot eliminate concerns about the further escalation of risks. Therefore, we determine that if the reciprocal tariffs take effect in full on April 2, risks could rise sharply, and the probability of the Federal Reserve cutting interest rates in June would also decrease. But if it turns out to be "loud thunder but little rain", the probability of a June rate cut by the Federal Reserve will still be considerable, and market pressure will ease. Although this risk cannot be ruled out, it should be noted that Trump will also be constrained by the backlash of inflation and the reality of midterm elections. If inflation spirals out of control, forcing the Federal Reserve to tighten policies (Powell's term as chairman of the Federal Reserve ends in May 2026), it will inevitably impact the US stock market and the US economy, potentially affecting the midterm elections at the end of 2026 (the current Republican Party only holds a narrow five-seat lead in both the House and Senate), which explains why tariff policies so far have been "more talk, less action" ("The Near Worries and Long-term Concerns of Tariffs").

Chart: Trump’s tariff policy has undergone multiple reversals.

If the tariff policy does not exceed expectations, from the perspective of matching real interest rates and natural interest rates, under the baseline scenario, the Federal Reserve still needs to cut interest rates twice this year (another 50-bp reduction), corresponding to a central level of the 10-Year T-Note yield of about 4~4.2%. 1) From the perspective of returning monetary policy to neutrality, referencing the average value of natural interest rate calculations from the Federal Reserve model and dot plot, the actual natural interest rate in the USA is around 1.3%, while PCE may be around 2.5%~2.7%, making a reduction of 2 times by 25bp to 3.8%~4% a reasonable level. Assuming that the term premium turns positive after the tapering ends, given a range of 30-50bp, the central yield of US Treasury bonds corresponds to 4~4.2%.

Chart: The gap between the USA's natural interest rate and the actual interest rate (1.79%) has further narrowed to 0.79 percentage points.

Chart: We believe that under the baseline scenario, the Federal Reserve will still have 2 interest rate cuts this year (i.e., corresponding to another 50bp reduction), corresponding to a central yield of US Treasury bonds of about 4~4.2%.

What does Assets mean? In April, focus on tariff risks and growth policies; as long as the current policy uncertainty can converge, the USA stock market is a good entry point.

From the perspective of Interest Rates expectations factored into Assets, most Assets expect more hawkish outcomes than the Federal Reserve. Therefore, once the Interest Rates expectations return, it will provide an opportunity to 'do the opposite'. Our calculations show that the Interest Rates expectations factored into various Assets are more hawkish compared to the Federal Reserve's dot plot (two times this year). Based on a calculation of 25 basis points per instance, the current expected Interest Rates cuts in the next year are: Federal Reserve dot plot (2 times) > US Treasury (1 time) > Nasdaq (0.6 times) > Gold (-0.2 times) > Copper (-0.6 times) > S&P 500 (-1.6 times) > Dow Jones (-1.8 times).

Chart: The Interest Rates expectations factored into various Assets are more hawkish than the Federal Reserve's dot plot (two times this year).

This indicates that the USA stock market, especially the cyclical style Dow Jones, has the least included expectations, while S&P 500 and Dow Jones have even factored in the expectations of two rate hikes. This suggests that once the Interest Rates expectations return, there will be substantial correction opportunities for the USA stock market. In the short term, the support levels for S&P 500 and Nasdaq are around 5600 and 17600 respectively, with short-term rebound momentum being insufficient due to the inability to falsify the uncertainty of Trump's policies. Under the baseline scenario, we estimate that a 10% profit growth for the S&P 500 Index in 2025 corresponds to roughly 6300-6400. In contrast, Gold has the highest included expectations, indicating that due to recent risk factors being largely pre-factored, any additional boost upon the return of Interest Rates expectations is limited; 'thinking and doing the opposite' with US Treasury remains a stage trading opportunity.

Chart: Thinking and doing the opposite with US Treasury, short-term trading long opportunities.

Chart: In the benchmark scenario, we estimate that a 10% profit growth for the S&P 500 Index in 2025 corresponds to approximately 6300~6400.

The short-term market is still subject to several unverifiable risks, and we can observe the policy developments in April. If growth policies such as tax cuts progress slowly, but tariff risks (for example, whether to impose global comparable tariffs) escalate further, the market may face increased volatility risk. Conversely, as long as the current policy uncertainty can converge, valuations have already squeezed out some bubbles, interest rate cuts return, and the introduction of growth policies will provide good entry points for US stocks. The convergence of policy uncertainty is key, but it is also where market divergence lies.

[1] https://www.federalreserve.gov/newsevents/pressreleases/monetary20250319a.htmB

[2]https://www.piie.com/blogs/realtime-economics/2025/trumps-threatened-tariffs-projected-damage-economies-us-canada-mexico

[3]https://www.piie.com/research/piie-charts/2024/trumps-economic-policies-could-stoke-inflation-and-hurt-us-economy

Editor/jayden